How expecting inflation could lead to more strikes

The key decade for salary rises is between the mid-20s and the mid-30s (Photo: Alamy)

When inflation is high for any extended period, people start to expect it to remain so. The latest (June) Citi/YouGov inflation tracker shows the public expecting inflation of 3.9 per cent over the next twelve months. Apart from a large downward blip in April 2011 (to 2.9 per cent), this figure has been rising fairly steadily since its December 2008 trough of 0.8 per cent.

Historically (data go back to 2005) these expectations were very solidly anchored on around 2.5 per cent (the old pre-2003 RPIX inflation target) – indeed, they had only deviated by more than 0.2 per cent from that 2.5 per cent norm in one month (July 2006) until 2008. That was natural, of course – from the introduction of inflation targeting in 1992 until April 2007, the inflation target was never once missed. The reaction to that first above-3 per cent miss was fatal – no admonishment from Chancellor Brown (who doubtless wished to avoid a row just before his departure to be Prime Minister); and Monetary Policy Committee members giving speeches telling us we had all "misunderstood" the inflation target and that it wasn't really a "miss" if inflation went above 3 per cent. So, of course, next time inflationary pressures came around, in 2008, it wouldn't count as a "miss" if inflation went above 3 per cent again.

Well, inflation went above 5 per cent, and inflation expectations naturally rose as well, peaking at 4.4 per cent in September 2008. With the large escalation in the financial crisis that month, and all the press discussions about the deflation to come, inflation expectations plummeted to 0.8 per cent by December that year, before commencing a gradual rise back to the latest figures.

It has been widely remarked that rises in average wages have not kept pace with inflation over the past few years. But of course some of that can be accounted for by stagnation in starting salaries. People are still receiving wage rises when they are promoted, or as they advance within pay scales. So from the individual point of view, as opposed to the economy as a whole, starting wages rising less rapidly than inflation does not have to mean real wage falls. We can get a handle on this effect by considering the statistics on how much more people earn at different ages. The key decade for salary rises is between the mid-20s and the mid-30s. Over that period, people's salaries rise (in addition to any changes in base salary) at just under 3 per cent per year. With average earnings rising at about 2 to 2.5 per cent per annum, that means that inflation up to about 5 per cent is still compatible with salaries for individuals rising in real terms for that key decade. So if inflation is not expected to be more than about 5 per cent, we could expect only fairly limited worker resistance to average real wage erosion.

But once expected inflation goes above 5 per cent, workers have much less ability to protect themselves from inflation by achieving promotions etc. So at that point we could expect wage demands to shoot up. That point is likely to be passed later this year – indeed, we are perilously close to it already. At that stage, firms will either have to pay more, or industrial unrest will not be a purely public sector phenomenon.